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A Bitcoin Primer

Since Bitcoin's largest exchange went bankrupt, rumors have been swirling about technical incompetence and fraud within the organization. The world's largest virtual currency continues to make headlines like this, but many still don't have a clue about the inner workings of Bitcoin or its influence.

To better understand Bitcoin, we sat down with Edward Felten, Robert E. Kahn Professor of Computer Science and Public Affairs at the Woodrow Wilson School and director of the Center for Information Technology Policy. He provided us with a primer to the world's now-largest cryptocurrency.

Q: What is Bitcoin? Who invented it?

Felten: Bitcoin is a form of digital currency. That is, it's a tradeable commodity that exists only in digital form.

Bitcoin was created by someone called “Satoshi Nakamoto,” although that name has long been believed to be a pseudonym. Several investigators have claimed to have identified the real Satoshi – most recently Newsweek’s article about a California man named Dorian Satoshi Nakamoto – but these claims have been met with skepticism from the Bitcoin community.

Q. Where do you keep Bitcoins?

Felten: Bitcoins are purely digital. If they can be said to live anywhere, it is in a data structure called a “blockchain." This is a sequence of data blocks containing information about transactions. It's the same thing as a “public ledger,” and it is maintained by participants in the Bitcoin system.

Every Bitcoin is owned and controlled by a secret key. So, rather than keeping the coin itself, you must keep your secret key somewhere safe. Most users do this through specific software applications or storage on their personal computers. Others rely on online Bitcoin wallet services that manage keys on users’ behalf.

Q: How do you earn and spend Bitcoins?

Felten: The owner of a Bitcoin can transfer the coin’s value to somebody else – another secret key. The current owner of a coin must digitally sign the transaction. The signature itself is just a pair of numbers that have a special mathematical property such that only someone who knows the public key could have created the signature. In some ways, a Bitcoin transaction is like writing a check; the transaction says who is paying and how much, as well as who is receiving that value. The transaction is signed by the paying party.

A Bitcoin transaction will usually be part of a broader exchange. For example, you might give me dollars, and in exchange I might create a Bitcoin transaction that transfers some Bitcoins to you. Then, you might create a Bitcoin transaction giving those Bitcoins to a merchant like Overstock.com in exchange for some item that they will ship to you.

You can also create new Bitcoins by "mining," but it is really no longer economically sensible for everyday people. The cost of electricity that you will use through mining easily outweighs the expected value of the Bitcoins you earn.

Q. What is the value of a Bitcoin? And can you trade in dollars for Bitcoins?

Felten: Bitcoins can be traded for dollars and other traditional currencies on Bitcoin exchanges, which function like foreign exchange markets. The dollar price of a Bitcoin is set by supply and demand. As of March 7, 2014, each Bitcoin costs about $650, so the total notional value of the 12.5 million Bitcoins in circulation comes to about $8 billion.

Q. Do you have to pay taxes on Bitcoins?

You’ll have to ask the IRS or your tax lawyer. It’s unlikely that you can escape taxation by keeping your assets in Bitcoins.

Q. What's the difference between Bitcoin and its competitors – Litecoin, Ripple and Dogecoin?

Felten: Each “altcoin” has its own slightly different value proposition. For example, Litecoin can confirm transactions more quickly than Bitcoin, and Ripple organizes its markets differently. Bitcoin has the advantage of being larger and more widely accepted, but altcoins can survive if they offer their own advantages that some users want.

Q: How might Bitcoin affect the economy going forward?

Felten: Bitcoin will probably continue to be a small but measurable portion of the overall economy. In the long run, Bitcoin and other cryptocurrencies like it will enable new business models and will increase competition in the financial industry.

Q. What is the future of Bitcoin?

There are three ways to look at this: the future of Bitcoin companies, the future of the Bitcoin currency/technology itself and the future of cryptocurrencies more generally.

The Bitcoin business sector is undergoing a shakeout in which less-sophisticated companies – technically or financially – will either be driven out or will adapt and improve. The largest Bitcoin exchange, Mt. Gox, recently went broke with rumors swirling about technical incompetence and fraud. Other exchanges have had significant thefts. Financial regulators are likely to step in and enforce stronger consumer protections. There will be turbulence, but, in the end, the maturation of this sector will be good for users of Bitcoin.

The technology itself will continue to evolve slowly. By this point, the pros and cons of Bitcoin as a technology are mostly understood. Even if companies come and go, I expect Bitcoin technology to continue operating in roughly the current mode for a few years, as long as people continue to be interested in using Bitcoin as a store of value or medium of exchange.

What is most remarkable about Bitcoin is its demonstration that a cryptocurrency – a purely virtual currency built on cryptography and distributed computing, and governed by consensus rather than any centralized authority – can exist and operate. Even if Bitcoin itself dies, cryptocurrencies will continue to exist and will provide a new type of monetary instrument. It is entirely possible that another cryptocurrency will displace Bitcoin due to technical improvements, but it seems very likely that a cryptocurrency of some type will be an important form of money in the coming years.

Q. What threats, if any, does Bitcoin pose in terms of security?

Felten: Your Bitcoins are controlled by your secret key, so an intruder who gets your key can steal your Bitcoins. There are more complex ways to protect coins, such as “cold storage,” which basically means storing your coins anywhere other than an Internet-connected device. For example, Bitcoins can be archived on paper (so you could scan it back into a computer) or on a storage device that is locked up somewhere. However, these are inconvenient. Many people rely on online wallets to protect their coins, but these create a risk of misbehavior by the wallet provider.

There are larger concerns about privacy of Bitcoin transactions. On one hand, transactions must appear on the public ledger, which everyone can see, so people can see money flowing into and out of your wallet. On the other hand, wallets are identified by keys that are not publicly linked to anyone’s real-world identity. There has been a lot of research surrounding whether and how one might identify the owner of a particular key.

The privacy issues connect to concerns about the use of Bitcoin for criminal purposes such as money laundering. Law enforcement agencies have had some success in tracing the ownership of coins associated with illegal activity so that Bitcoin is not an easy safe haven for criminal money. Nonetheless, this will continue to be an area of concern for governments and for legitimate Bitcoin businesses.

WWS Reacts is a series of interviews with Woodrow Wilson School experts addressing current events. Quotes from this article may be used without permission. Interested parties may also link to this story.